Belling the Cat

Sometimes even the best of ideas are only good in theory because they are impossible to implement in practice. This holds true in the financial world as well. Each year, academic financial research generates hundreds of research papers that highlight potential ways for investors to possibly gain insight on the direction of the stock market. Many of these findings are found using less than rigorous scientific methods, such as basing it on who holds political power in Washington or using the weather or the alignment of planets to predict future stock movement.

However, even after a research item held to rigorous standards uncovers a possible solution, when the research is brought into the real world, it cannot be followed. While sounding like a good idea, it is still unable to provide investors with any actionable insight.

One approach that has attracted considerable attention in recent years is adjusting investments based on the cyclically adjusted price/earnings ratio (CAPE ratio). This approach, developed by academics Robert Schuller of Yale and John Campbell of Harvard, seeks to provide investors with a way to improve their portfolio performance by over-weighting stocks (owning a higher percentage) during periods of low valuation and under-weighting stocks (owning a lower percentage) during periods of high valuation. Seems simple enough, right?

Well, as it turns out, the challenge of profiting from this approach and many other quantitative indicators is to design a trading rule to identify the correct time to under-weight or over-weight stocks. It is not enough to know that stocks are above or below the long-term average valuation. How far above valuation before investors should reduce equity exposure? And at what point will stocks be sufficiently attractive for repurchase: below average, average, slightly above average? It may be easy to find the rules that have worked in the past, but much more difficult to achieve success by following the same rules in the future.

Belling the Cat

These research theories remind me of the children’s fable, “Belling the Cat.” It is the Aesop fable where mice who have seen other mice getting picked off by a cat decide to call a meeting. The reason for the meeting is to devise a plan so they do not continue to lose members of their clan to the cat. After much discussion, a young mouse proposes a solution: They should tie a bell around the cat’s neck to alert them when the cat is nearby, thus allowing them time to exit before the cat is able to pounce. Many of the mice are surprised that they had not thought of this great idea earlier.

However, one wise mouse asks the following question: “Who will bell the cat?” For it is one thing to say that something should be done, but quite a different matter to successfully execute it. As in the case of these financial research papers, it is one thing to pick out tactics that may work in a research lab, but quite another to implement them in the real world.

A successful timing strategy is the fountain of youth of the investment world. For decades financial researchers have explored dozens of quantitative indicators, as well as various measures of investor sentiment, in an effort to discover the ones with predictive value. The performance record of professional money managers over the past 50 years offers compelling evidence that this effort has failed.

As access to investing expands, it becomes even more important to adopt an investment plan that does not try to actively pick stocks or time the market. Investors actively trading are not just potentially missing out on the expected return of market, they are also constantly under stress, worrying about how the latest news alert may impact their long-term financial plan.

A better approach is to develop an investment plan for the long term by working with a financial advisor who can help prevent you from making mistakes like trying to time the market. This way you can get out of the game of worrying and guessing by having a plan in place.

Remember, there is no proven way to target the best days to invest or when to move out of the market to avoid the worst days. The evidence suggests staying in the market through good times and bad times will help you achieve your long-term goals. Remember—it’s much harder to “bell the cat” in reality.